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There’s quite a lot going on in the financial markets and in the world – so much that I don’t think I can go into great detail. But here are some highlights:

On the one hand we have the biggest mix of potential market-impact problems I have seen in my 23-year professional career. On the other hand we have the sense that, ever since the Fed folded on Quantitative Tightening in 2018, they are unwilling to allow financial assets to drop. At least that is the market hope. Can the Fed be our Atlas? Or will Atlas shrug?

Precisely what are the problems? Slowing business, a slowing economy, a trade war, crazy valuations, a Fed that’s already used up almost all of its ammo, a potential pandemic, and potential election year chaos. I’ll go through those in order:

Business (top line revenue and bottom line profits) has been slowing for at least a year. We actually saw marginal growth in the last quarter of 2019, due entirely to the five largest stocks. Russell 2000 stocks continued to see shrinking bottom lines, as is true with most companies in aggregate. As I’ve written about before, there’s a lot of fiddling around with the numbers with those big companies, and while I haven’t done a forensic deep dive, I’m suspicious of their numbers. What are the chances that they’re overstating assets, for instance, much like we saw in 2000? That doesn’t really matter, though, in terms of our portfolios, as they’re not within light years of prices I’d buy them at. The point is, it’s been a while since business was broadly strong and I don’t see that changing.

In general, business growth has been much worse than economic growth. This largely due to two items that do not touch business growth, but are part of economic growth – government spending, and lower imports increasing GDP even though exports are flat.

Looking at the economy – strictly by the numbers and without trying to account for business problems, trade wars, and pandemics, while I can say the economy is highly likely to slow down some, there’s nothing to say it’s going to crash. That’s somewhat similar to what we saw in 2000, where the economy actually stayed pretty good through all of 2000. That said, right now it is pretty hard to get behind economically sensitive areas like manufacturing. The slowing economy, all by itself, seems like a pretty minor investment management problem. It just helps defensive vs. cyclical names as a potential market rotation, again similar to 2000.

As for the trade war, who really knows what happens. We had a ‘trade deal’ that was more about both sides looking good than actually accomplishing anything. The numbers promised looked awfully unlikely, and with the problems in China, they’re just not going to happen. I’m not sure anyone really cares, though. What is important is that the U.S. continues to want to stop the Chinese from grabbing technology advances, so they’re restricting the sale of US semiconductors and fab technology to China, along with some other stuff. Breaking global supply chains is pretty messy, and this seems likely to be an ongoing problem, particularly in the tech space.

Stock valuations are basically around the levels we saw in 2000. Wow. Of course, with the apparent Fed support of this market, who cares about valuations? But even outside of valuation there’s trouble. Market breadth is getting smaller and smaller. At this point, five mega companies (Apple, Amazon, Google, Microsoft and Facebook) are basically the market performance we see on TV. That’s a fragile market. We’ve seen this show several times before, and it’s just a matter of time before you see a downturn. Let me also point out that at this point the bubble observer, the Financial Crisis Observatory¹ , is showing the Nasdaq and the Dow as bubbles. Their last bubble signal was July of 2017. If it is an actual bubble this time (no surprise to readers – I think it is), what you tend to see is this tension between the risks being taken and the expected rewards. The market knows it’s taking risks, so it demands outsized rewards. What you get is something that goes up and up until it pops, like we saw March 10th 2000. Are we setting up for something like that?

And then we have the Fed. For the last two recessions, if memory serves, the Fed cut rates by 500bps (5%). Today, there aren’t 500bps of cuts available. In fact, the Fed is using emergency procedures ala repo activity injections of money and Treasury bill buying to keep financial markets from falling apart. Here also, if you think about that – Wow. That’s not a good sign of a robust market. We actually had pretty similar setups in 2000 and 2008 with Fed emergency funding trying to prop things up. What happens when we inevitably have a recession?

The potential pandemic is interesting. As happens in market manias, people tend to believe there are no problems. At first people thought it would have minimal impact, like SARS-lite. Now they’re admitting it may hit first quarter GDP in China, and maybe the second quarter a little. China says most state owned enterprises are back at work. But if they say so, then why does traffic data show practically no one on the roads or in trains? Why is China air pollution down so much? How bad is this going to be in China? I don’t think anyone really knows, but to the best of my ability, I’d say it looks fairly bad. Goldman Sachs has talked about a 0% China GDP number for Q1. It’s really affecting industry, and since they are the manufacturing center of so much, that’s going to hurt the world, including affecting Q1 for the U.S. Will it hit Europe, the rest of Asia, and the US eventually? The CDC (Center for Disease Control) sure seems to think so, and it’s hard for me to imagine it doesn’t happen eventually. What will that look like? That’s really hard to say. Will there be progress on a vaccine, will we know more about how to deal with it, will it mutate? There are a lot of questions that can’t really be answered.

Lastly, a lot of people are willing to just assume that Trump wins reelection in a landslide. I’m not nearly so sure. There seems to be a huge swath of disaffected people. If they turn out, the election could be very much up for grabs. Trump barely won last time (according to the Democrats, he didn’t win), and it won’t take much for that to change. Also the situation now isn’t the situation in November 2020. Particularly if the market starts sinking, if the economy gets worse, or if a pandemic hits – what impact might any of those events have? My honest belief is that Trump doesn’t win in November. The two frontrunners in the Democratic party are currently Sanders and Bloomberg or perhaps Buttigieg. That said, to make it even more fun the latest odds I’ve seen say the leading candidate is a dead heat between Sanders and a brokered convention. If it’s a brokered convention, the party leaders get a lot of choice by way of their superdelegate votes. That could be a circus, and to me it’s really hard to say with confidence who wins right now. The March 3 Super Tuesday primaries will tell us more.

On the flip side of all the uncertainties is the Fed, who is doing their best Atlas impression. Can they keep the party going? I think that’s very unlikely and I don’t think it’s nearly the Fed priority the market likes to think it is. For instance, the Fed balance sheet hasn’t moved in over a month and they’re actively shrinking repo availability. Additionally, global liquidity has been headed down so far this year. It’s worth noting that the same basic thing happened when the last two bubbles popped. Freely available capital became less free. The one thing that bulls do have going in their favor is that the Fed keeps buying $60B of T-bills a month, which it said would last at least into the second quarter. Great, but doesn’t that mean they could stop in April? I particularly bring that up because they’re eating up the whole T-bill market. Bulls are convinced they’ll just shift into buying longer term Treasury coupon bonds, but what if that’s too sanguine?

OK, that was a lot of words. With that background, how are we positioned and what do I think will happen?

First, humans are funny in that they have a strong tendency to think the recent past and the near future will be the same. At some point things will change. Trees don’t grow to the sky no matter how much we may want to believe.

Second, I’d like to try harder to come up with a scenario where this party lasts forever, but I haven’t yet managed to do it. There are just too many problems to solve. Can we thread that needle? I suppose anything is possible, but as a thinking person I find that vanishingly hard to imagine. I basically have the assumption this is going to end – the only question is how and when. Throughout history, when faced with scenarios like this, something breaks. Could this time be different? It’s very hard for me to see that.

The basics of this scenario are very similar to what we saw in 2000. In 2000 we’d seen several years of easy money accentuated by a frenzy at the end with the Fed insertion of Y2K liquidity. We have the same situation here, with years of easy Fed money followed by an exclamation point of recent repo and T-bill liquidity. In 2000, we turned down the taps shortly after the beginning of the year, and this time we did something similar, with the Fed balance sheet basically flat so far in 2020. In 2000 the party went on a bit before rotating to value and later crashing, and we’re seeing the market still trying to party here as well.

What caused the market to rotate and crash in 2000? I can’t think of a good description that I’ve read. Having lived it, what I’d tell you is we had a lot of restricted stock in crappy tech companies that unlocked around March 10th, and that swamped demand for those stocks. The crap crashed and people ran to value. I think that was the pin that caused the bubble to pop. I’d also tell you I didn’t figure that out until a week or three after it happened. I had been waiting for a long time for something to happen, and finally it did.

What will cause problems this time, and when? There are so many potential pins out there it’s hard to settle on one. I’m more comfortable guessing on timing, though I also admit it’s a guess. The reason for that is a lot of things line up with April. In April we’ll start seeing the main thrust of Q1 earnings reports. With generally positive guidance meeting the reality of China problems, that could be interesting.

April is also when it’s generally believed the Fed will have to make a tough choice on what to do with T-bill purchasing, as they will have bought up a significant portion of the market and April is as long as they originally said they’d go anyway. On February 19 the Fed confirmed my speculations when they released the minutes of the January FOMC (Federal Open Market Committee) meeting. It appears that their plans are to end the T-bill purchasing in April and not morph it into Treasury coupon buying. To me, the highest-odds chance of seeing a problem is in April.

What happens until then? That’s really hard to say. In 2000 it was largely a party until it wasn’t. Then came March 10 and it was like night and day. In 2008, there were warning signs starting in 2006, and fits and starts in 2007 until things started to get more obviously bad in October of 2007. The big blowup finally came in September-October of 2008. How does this time go? Beats me. You could argue we’ve already seen some canaries pitching over, like BYND (Beyond Meat) and so on. I’m not sure that’s a very strong reed to lean on, but I would look hard at movement in some of these troubled companies with absurd valuations to indicate maybe the end is nigh. Even more so, I’d look for a more obvious rotation out of growth and probably into quality before the market really goes down. Of course, a lot of this is guesswork, but outside of the Fed induced excitement from the fourth quarter of 2019, that’s generally what we’ve seen– defensive stocks starting to outperform growth stocks. That rotation could become more obvious.

In terms of what happens next, that’s why we’re fairly conservative now. If history is a guide, and given this fragile market, you can lose a lot of money very quickly as buyers disappear for some stocks. There are lots of guys playing the tune Chuck Prince of Citigroup did in 2008, and dancing while the music is playing. But now as then, when the music stops it’s going to be hard to get out of the exit. I mean who in the world buys stuff like SPCE (Virgin Galactic) and TSLA (Tesla) here? We don’t. I suspect there are places in this market where you can make some money and other places where you can lose a life-changing amount. That mostly implies a rotation, but again, think of what happened in 2000. Don’t own Pets.com.

Thus, we’ve stayed fairly conservative. If this is like other times of trouble, either looking domestically or internationally, you generally want to stick with high quality assets. You may not get paid today, but you’ll emerge better over time. In addition to quality, we’ve also tended to stay defensive. The one thing we’ve been willing to stick our neck out on is more inflationary plays, particularly energy. They’ve been whacked of late and seem like a good risk/reward, particularly compared to the broad market. There’s certainly downside risk, but there’s also upside possibility. I may have bought into the area too quickly, but I think it may have reasonable legs, so I’m willing to stick around and collect some nice dividends while I wait. Remember, it’s not easy to say the world economy is going to fall apart here, but oil has been priced that way. Additionally you have OPEC and terror factors to consider.

If I had to guess, and there’s a lot of guessing here, I would guess we’re going to see some crappy stocks start to flame out, the market will edge towards quality stocks, then this fragile market will just give up one day. In 2000, that happened on March 10th. I don’t know what day it will be this time, but I would guess it’s something similarly dramatic here. This looks and acts like a bubble, and that’s how bubbles pop. And to remind people, in 2000 the market rotated much more than it crashed. Crashing happened later.


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